Chapter 5: Regulatory Framework (Part 6 of 6)

This sixth and final part of the Chapter 5 study notes covers the vital international tax compliance standards, anti-money laundering policies, market integrity guidelines, and capital-raising codes that Category III Alternative Investment Funds (AIFs) must comply with under various regulatory statutes in India.

5.20 Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS)

The Foreign Account Tax Compliance Act (FATCA) is a United States federal law enacted to combat offshore tax evasion by U.S. citizens. To implement this globally, the Organisation for Economic Co-operation and Development (OECD) developed the Common Reporting Standard (CRS), which facilitates the automatic exchange of financial account information among partner jurisdictions. India signed the multilateral agreement to exchange information under the CRS on June 3, 2015.

To operationalise these commitments, the Government of India amended the Income-tax Act, 1961, and notified Rules 114F to 114H of the Income-tax Rules, 1962, along with detailed compliance guidance notes issued by the Central Board of Direct Taxes (CBDT).

5.20.1 Key Compliance and Reporting Mandates

• Mandatory Self-Declaration: Since January 2016, it is mandatory for all Indian and Non-Resident Indian (NRI) investors subscribing to a Category III AIF to submit a completed FATCA/CRS self-declaration form.
• Target Disclosures: FATCA reporting is specifically triggered for investors identified as "U.S. persons". CRS reporting is mandatory for investors residing in any of the other signatory countries across the world.
• Due Diligence Checks: Category III AIFs must register with the U.S. Internal Revenue Service (IRS) to obtain a Global Intermediary Identification Number (GIIN). The fund is legally required to identify and verify the direct and indirect beneficial owners of its investors.
• Required Particulars: Investors must disclose their Name, Address, Place of birth, Country of birth, Nationality, Gross Annual Income, Occupation, Permanent Account Number (PAN), details of Tax Residency in other countries along with their Tax Identification Number (TIN), or Social Security Number (SSN).
• Change in Status: Investors must notify the Category III AIF of any change in their FATCA/CRS-related information or tax residency status within 30 days of such change.
• Consequences of Non-Disclosure: If an investor fails to provide the required FATCA/CRS declarations, tax documentation, or waivers, the AIF manager reserves the right to reject their application, compulsorily redeem their existing units, and report the default to the tax authorities.

5.21 SEBI (Prohibition of Insider Trading) Regulations, 2015

The SEBI (Prohibition of Insider Trading) Regulations, 2015 (the "PIT Regulations") are designed to protect the integrity of capital markets and safeguard common investors from asymmetric information advantages. These regulations strictly prohibit trading in securities by individuals who have access to unpublished price sensitive information (UPSI).

5.21.1 Definitions and Core Concepts

Connected Person

A Connected Person is any person who has been associated with a listed company, directly or indirectly, in any contractual, fiduciary, or employment capacity during the 6 months prior to a concerned transaction. This association includes being a director, officer, or employee, or holding any professional or business relationship that allows access to UPSI.

Deemed Connected Person

Because Category III AIFs interact closely with investee companies and handle large capital pools, they are deemed to be connected persons under the PIT Regulations. Any access they have to non-public company data classifies them as insiders.

Unpublished Price Sensitive Information (UPSI)

UPSI refers to any information relating to a company or its securities, directly or indirectly, that is not generally available to the public and which, upon becoming generally available, is likely to materially affect the market price of the securities. Under the PIT Regulations, UPSI includes:

• Financial results
• Dividends
• Changes in capital structure
• Mergers, de-mergers, acquisitions, delistings, disposals, and expansion of business
• Changes in key managerial personnel

5.21.2 Permissible Exceptions for Insider Trading

No insider is permitted to trade in securities of a listed company while in possession of UPSI. However, the PIT Regulations provide specific legal exceptions where such trades may be permitted:

• Off-Market Inter-se Transfers: Off-market transfers between insiders who are in possession of the same UPSI, provided both parties made an informed decision and the transaction is reported to the company within the prescribed timeline.
• Block Deal Window: Transactions executed through the exchange's block deal window mechanism between parties possessing the same UPSI.
• Regulatory/Statutory Obligations: Transactions carried out in good faith to meet a statutory or regulatory obligation.
• Stock Options: Trades executed pursuant to the exercise of stock options where the exercise price was pre-determined.
• Institutional Chinese Walls: In case of non-individual insiders (such as a Category III AIF), trades are permissible if the fund demonstrates that:
  1. The individuals making the investment/trading decisions were different from the individuals in possession of the UPSI.
  2. Appropriate Chinese Wall and information-barrier arrangements were in place to ensure that no UPSI was communicated between the team in possession of the information and the team executing the trades.
• Approved Trading Plan: Trades executed pursuant to a pre-scheduled Trading Plan formulated in accordance with PIT guidelines. The plan must be submitted to the Compliance Officer for approval and publicly disclosed before trading commences.

5.21.3 Compliance Requirements for AIF Sponsors and Managers

1. Structured Digital Database (SDD)

The Board of Directors or heads of the organisation (in this context, the Sponsor or Investment Manager of the Category III AIF) who handle UPSI must maintain an internal Structured Digital Database (SDD).

• Database Contents: The SDD must contain the nature of the UPSI shared, the names of the persons who shared the information, and the names of the persons with whom the information was shared along with their Permanent Account Number (PAN) or legal identifier.
• Operational Controls: The SDD must be maintained internally and must not be outsourced to third-party service providers. It must include security features such as time-stamping and audit trails to prevent tampering.
• Retention Period: The database must be preserved for a minimum of 8 years after the completion of the relevant transactions, or until the conclusion of SEBI proceedings, if any.

2. Code of Conduct & Internal Controls

The Investment Manager and Compliance Officer of the Category III AIF must implement internal controls to regulate and monitor trading by employees, which include:

• Formulating a written code of conduct to regulate, monitor, and report trading by employees and connected persons.
• Maintaining lists of all employees and persons with whom UPSI is shared, and ensuring they sign confidentiality/non-disclosure agreements (NDAs).
• Conducting periodic internal reviews to evaluate the effectiveness of these controls.
• Formulating written policies and procedures for conducting inquiries in the event of a leak or a suspected leak of UPSI.
• Framing a comprehensive whistle-blower policy and raising employee awareness about it.

5.22 SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003

The NISM workbook index lists Section 5.22: SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003 (commonly referred to as the FUTP Regulations) on page 150.

Note: While the detailed textual contents of this specific section are not fully extracted in the provided workbook passages, the FUTP Regulations broadly prohibit any form of market manipulation, deceptive practices, spreading of false rumors, front-running, wash sales, or circular trading by market intermediaries (including AIFs, Sponsors, and Managers) to protect the interests of investors and preserve market fairness.

5.23 Prevention of Anti-Money Laundering Act, 2002 (PMLA)

Category III AIFs are classified as "financial institutions" or "reporting entities" in India and must comply with the strict guidelines of the Prevention of Money Laundering Act, 2002 (PMLA) and the rules framed thereunder.

5.23.1 Client Onboarding and CKYC Registration

• Mandatory Verification: At the commencement of a client relationship, the Category III AIF must verify the identity of the client, obtain information on the purpose and intended nature of the business relationship, and evaluate risks associated with Politically Exposed Persons (PEPs).
• Beneficial Ownership: The AIF must determine whether the client is acting on behalf of a beneficial owner and verify the identity of the Ultimate Beneficial Owner (UBO) to establish the natural person who ultimately owns or controls the investment.
• Central KYC Registry (CKYCR): The Category III AIF must register on the CKYCR portal by submitting its Sponsor, Manager, and Compliance Officer details.
  • The AIF must upload the investor's KYC details, along with scanned copies of their Proof of Address (PoA) and Proof of Identity (PoI), within the specified template.
  • The unique KYC Identifier generated must be communicated to the investor. If an investor has an existing KYC Identifier, the AIF can download their verified records directly from the portal.
• Foreign Portfolio Investors (FPIs): For FPIs, a risk-based KYC framework is adopted, and KYC documents are uploaded to the KYC Registration Agency (KRA) portal for ease of access by other intermediaries.

5.23.2 Beneficial Ownership (UBO) Thresholds

Under the PMLA rules, AIFs must identify the beneficial owners of non-individual investors:

• Partnership Firms & Unincorporated Associations: The UBO is identified based on an ownership or entitlement interest threshold of 15 percent.

5.23.3 Suspicious Transaction Reporting (STR)

All AIFs must monitor account activities and report suspicious transactions to the Director - Financial Intelligence Unit (FIU) - India.

Red Flags for Suspicious Transactions:

• Investors whose identity is difficult to verify or who appear uncooperative.
• Asset management requests where the source of funds is unclear or inconsistent with the client's apparent financial standing or business line.
• Clients located in high-risk jurisdictions.
• Sudden, unexplained increases in investment volumes without apparent cause.
• Clients transferring large sums of money to or from offshore locations with instructions to pay out in cash.
• Attempted transfers of investment proceeds to unrelated third parties.
• Unusual corporate transactions involving offshore banks or businesses resembling shell export-import operations.

Principal Officer (PO) Appointment

Every Category III AIF must appoint a Principal Officer (PO) who is responsible for monitoring compliance, identifying suspicious trades, sharing information with enforcement agencies, and regularly certifying to the Board that the AIF's anti-money laundering policy is strictly followed.

5.23.4 Specific Entity KYC Rules

Non-Profit Organisations (NPOs)

Category III AIFs may receive investments from NPOs, such as societies registered under the Societies Registration Act, 1860, or Section 8 companies registered under the Companies Act, 2013. These NPO transactions must be reported, and the AIF must perform detailed KYC on them.

Family Trusts Exemption

Family trusts are set up with the specific objective of creating and managing wealth for the ultimate benefit of family beneficiaries. Family trusts are not required to register under the Registration Act, 1908.

• The Rule: Because family trusts do not fall within the definition of NPOs under the PML Rules, capital commitments received from a family trust are not subject to the NPO-specific PML reporting requirements.

Record Retention

The Custodian of a Category III AIF is required to preserve the original KYC records of FPIs for a minimum period of 5 years from the date of cessation of transactions. If any litigation is pending, the records must be retained until the final completion of the legal proceedings.

5.24 Foreign Exchange Management Act, 1999 (FEMA)

Cross-border capital transactions, inbound foreign investments, and outbound offshore investments by Alternative Investment Funds are strictly governed by the Foreign Exchange Management Act, 1999 (FEMA).

5.24.1 Categorisation of Capital Instruments

Under the FEMA framework, investments are divided into two primary categories: Non-debt instruments and Debt instruments.

1. Non-Debt Instruments

• All investments in equity instruments of incorporated entities (public, private, listed, or unlisted).
• Capital participation in Limited Liability Partnerships (LLPs).
• All investment instruments recognised under the Foreign Direct Investment (FDI) Policy.
• Investments in units of AIFs, Real Estate Investment Trusts (REITs), and Infrastructure Investment Trusts (InvITs).
• Investments in units of Mutual Funds and Exchange-Traded Funds (ETFs) that invest more than 50% in equity.
• Acquisition, sale, or dealing directly in immovable property.
• Contributions made to trusts.
• Depository receipts issued against underlying equity instruments.

2. Debt Instruments

• Government bonds.
• Corporate bonds.
• All tranches of securitisation structures that do not constitute an equity tranche.
• Borrowings by Indian firms through loans.
• Depository receipts whose underlying securities are debt instruments.

5.24.2 Strategic FDI vs. FPI Routes

The Indian FDI Policy permits foreign investment in Indian investee companies through two primary investment routes:

• Foreign Direct Investment (FDI): Strategic in nature, intended for long-term business purposes. FDI is triggered when a non-resident investor acquires 10 percent or more of the post-investment fully diluted paid-up capital of a listed Indian investee company. FDI is generally permitted under the Automatic Route.
• Foreign Portfolio Investment (FPI): Targeted financial investments where the investor holds less than 10 percent of the post-investment fully diluted paid-up capital of a listed company. FPIs must obtain prior SEBI registration before executing trades.
  • Breach Rectification: If an FPI's holding exceeds the 10% limit, they have a strict window of 5 trading days from the date of trade settlement to divest the excess holding.

5.24.3 AIF Automatic Route and Reporting Timelines

Non-resident investors can purchase or redeem units of a Category III AIF under the Automatic Route (without needing prior regulatory approval). If the Automatic Route is blocked due to sector-specific FDI restrictions, approval must be sought from the DPIIT through the Foreign Investment Facilitation Portal (FIFP).

All foreign exchange inflows and outflows must be reported to the Reserve Bank of India (RBI) through specific channels:

• Foreign Liabilities and Assets (FLA) Return: Category III AIFs with inbound or outbound foreign investments must file an annual FLA return by 15th July of every year using the RBI's FLAIR portal.
• Single Master Form (SMF): Mandatory for all Category III AIFs to report foreign inflows. The form must be filed on the FIRMS portal within 30 days of unit allotment and is verified by Authorized Dealer (AD) banks.
• Form DI: If an Indian AIF with downstream foreign investment makes subsequent downstream investments in another Indian company, it must report it as indirect foreign investment by filing Form DI with the RBI within 30 days of allotment.

5.24.4 FATF Deficiencies and Drawdown Freeze

• UNSC Sanctions: Under the PML Rules, the AIF Manager must verify that no foreign investor or beneficial owner is listed on the Sanctions List notified by the United Nations Security Council (UNSC).
• FATF Deficiencies: The foreign investor must not reside in a country identified by the Financial Action Task Force (FATF) as a high-risk jurisdiction subject to active countermeasures or having strategic AML/CFT deficiencies.
• Drawdown Freeze: If an onboarded foreign investor fails to meet these FATF/UNSC sanctions criteria, the AIF Manager is strictly prohibited from drawing down any further capital contribution from them until they comply.

5.24.5 Overseas Investments by Indian AIFs

Under SEBI and RBI guidelines, Category III AIFs can invest in equity or equity-linked securities of offshore companies incorporated outside India:

• Industry-wide Cap: Outbound investments are subject to an overall industry-wide cap of USD 1,500 million across all registered AIFs on a first-come, first-served basis.
• Scheme Concentration Limit: A Category III AIF scheme cannot invest more than 25 percent of its investible funds in offshore entities.
• Indian Connection: Investments are restricted to foreign offshore companies that have an established "Indian Connection" (e.g., front-office operations overseas with back-office development in India).
• No Joint Ventures: AIFs are strictly prohibited from investing in their own Joint Ventures or Wholly Owned Subsidiaries while investing overseas.
• Sanction Validity: SEBI's overseas investment allocation remains valid for 6 months, after which any unutilised limit lapses and is returned to the general industry pool.

5.25 SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations)

The SEBI (ICDR) Regulations, 2018 govern public offers, rights issues, and preferential allotments of securities by listed and unlisted companies in India. Category III AIFs active in primary issuances must adhere to several key requirements:

• Nominated Investor: Category III AIFs can act as a Nominated Investor to subscribe to securities in connection with public issues made by Small and Medium Enterprises (SMEs).
• Promoter Group Exemption: A Category III AIF is not deemed to be a promoter or part of the promoter group of an investee company solely by virtue of its equity holding, even if it holds up to 20 percent of the company's equity capital.

5.25.1 Mandatory Lock-in Restrictions

1. Initial Public Offers (IPOs)

• 6-Month Lock-in: The entire pre-issue share capital of an unlisted company held by non-promoters (including Category III AIFs) is locked-in for a period of 6 months from the date of allotment in the public issue.
• 1-Year Lock-in: If the IPO involves a fresh issue of shares and the majority of the proceeds are utilised for capital expenditure, the pre-issue shares held by the Category III AIF are subject to a 1-year lock-in.

2. Preferential Allotments

• 6-Month Lock-in: Shares allotted to Category III AIFs through a preferential allotment are subject to a lock-in period of 6 months from the date of allotment.
• 1-Year Lock-in: If the majority of the preferential allotment proceeds are utilised for capital expenditure, the lock-in period increases to 1 year.

3. Offer for Sale (OFS)

• Category III AIFs are permitted to divest their holdings to the public through an OFS.
• 6-Month Minimum Holding: To participate in an OFS, the equity shares must have been held by the selling AIF for a minimum period of 6 months prior to the filing of the draft offer document.
• OFS Notification: The AIF must submit a formal notice of its intention to sell shares in an OFS by 5:00 PM on T-1 day (where T is the day of the OFS).

5.25.2 Bidding and Pricing Rules in an OFS

• Retail Option: It is mandatory for the offeror (the Category III AIF) to provide retail investors with an option to submit bids at a cut-off price, in addition to submitting price bids.
• Bidding Timeline:
  • T-Day (Only Non-Retail): Only non-retail institutional/HNI investors are permitted to place their bids.
  • T+1 Day (Retail Bidding): Retail investors submit their bids on the subsequent day. The cut-off price is determined based on the bids received from non-retail investors on T-day.

Key Terms and Concepts for Exam Prep

Unpublished Price Sensitive Information (UPSI)

Any non-public corporate information (like financial results, dividends, or mergers) that, if disclosed, would materially impact the company's stock price.

Chinese Wall

The internal informational barrier established within a financial institution (like an AIF Manager) to prevent the transmission of UPSI from research/advisory teams to trading desks.

Ultimate Beneficial Owner (UBO)

The natural person who ultimately owns or controls 15% or more of a partnership firm or unincorporated association investing in an AIF.

Automatic Route (FEMA)

The regulatory channel allowing foreign investors to invest in units of Indian AIFs without requiring prior approval from the RBI or Government.

Nominated Investor

A regulatory status that allows Category III AIFs to subscribe to and market public issues floated by SME companies on dedicated SME exchanges.

💡 Quick Revision Nudge

• FATCA/CRS Self-Declaration: Mandatory for all Category III AIF unitholders since January 2016.
• PIT Connected Person: Association with a listed entity within the prior 6 months.
• Structured Digital Database (SDD): Must be maintained internally (no outsourcing) with time-stamping, and preserved for 8 years.
• PMLA UBO Partnership Threshold: Beneficial ownership is triggered at 15 percent.
• FEMA FDI vs. FPI: FDI is strategic, representing >= 10% of post-issue fully diluted capital; FPI is portfolio-based, representing < 10%.
• AIF Overseas Investment Scheme Cap: Outbound investment is restricted to a maximum of 25% of the investible funds of the scheme.
• OFS Notice Deadline: Must be submitted by 5:00 PM on T-1 day.
• OFS Bidding Timeline: Non-retail bids are placed on T-day; retail bids are placed on T+1 day.